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Attempts to Jumpstart Trend and Volatility Fall Short as a Clear Drive in Sentiment Alludes Traders

Attempts to Jumpstart Trend and Volatility Fall Short as a Clear Drive in Sentiment Alludes Traders

2010-03-05 07:41:00
John Kicklighter, Chief Currency Strategist
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Carry Trade
• Attempts to Jumpstart Trend and Volatility Fall Short as a Clear Drive in Sentiment Alludes Traders
• Officials Delicately Guide Greece to Financial Stability, Away from Economic Recovery
• Yield Forecasts Steadily Deteriorate as Slow Growth and Stimulus Withdrawal Dawn on Investors

A week ago, the markets were lacking direction; but volatility was a common element of otherwise indecisive price action. Today, investors are still holding off on a meaningful build or further unwind of speculative positions; and the lack of progress has further curbed the exaggerated swings in price action as the masses wait for guidance. The further diminishment of activity behind the capital markets can be largely attributed to a recovered sense of stability for Greece and its economy. However, this may very be reversed cause-and-effect relationship. The focus on Greece has likely diminished because of a general improvement in sentiment itself. We can see this turn towards a brightened outlook in certain corners of the market. The most accessible improvement was noted in equities. The Dow Jones Industrial Average has climbed since the beginning of February, showing a natural buoyancy and demand for yield that has contradicted an otherwise temperate market place. Yet, with this bias, it may be difficult to identify the hesitation that is preventing a revival of trend that would once again open the taps for speculative capital to refill the market. For equities specifically, the recent climb can be reconciled with background sentiment through the fact that the benchmark has kept a restrained pace on its climb and conspicuously avoided a retest of the high set just a month and a half ago. A better illustration of uncertainty can be measured in the currency market. Carry interest has lingered within a range since the index stopped climbing back in November. More specifically, the US dollar has turned to tight congestion for two weeks now. This aimlessness will not likely last for much longer.

Through the month of February, the top threat to global stability and investor optimism was the potential default of Greece and the implications it held for the European Union and beyond. Since this fear first graced the financial headlines though, we have seen panic dissipate as an immediate collapse wouldn’t play out in front of traders eyes and the policy officials slowly stepped into stem the bleeding. This week, the government has made the most progress on staunching the bleeding since the crisis state began. Backing up constant reassurances that the nation was in fact on path to meeting its ambitious deficit cutting goals, the government in the Mediterranean state caved to EU pressure and introduced additional austerity cuts to the tune of 4.8 billion euros. This would further lower financing costs for Greece and open the doors to a successful bond sale (which itself promotes confidence). The next step towards fortifying the nation’s bid to rouse the market’s support would be a public disclosure of the details to any aid package the broader Euro region plans to extend to the member should it be needed. In the end though, the confidence surrounding Greece is fully dependent on a general sense of confidence amongst all speculators (not the other way around). There are more prolific and engrained problems in the world should speculators only decide to pay attention. In China, leaders are trying to cool market activity to avoid an asset bubble (and are inadvertently sterilizing the strongest source of speculative optimism across the globe). In Japan, a public spat has developed between the BoJ and government that has the accountability of recovery being pushed back and forth. Back in Europe, the UK is facing credit warnings as the deficit looks like a necessary burden considering the economy is struggling to recovery – though an approaching election complicates the matter. Then there is the US, which is carrying a record deficit and is being assigned the blame for fueling speculative interests worldwide. There is plenty of fuel for any bearish fires should that initial spark find its way in. 

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Carry Trade

 Carry Trade
Carry Trade
Additional Information

What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.



Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.
 

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